Chapter 2
Wages, Salary, and Other Compensation

Except for tax-free fringe benefits (Chapter 3), tax-free foreign earned income (Chapter 36) and tax-free armed forces and veterans’ benefits (Chapter 35), practically everything you receive for your work or services is taxed, whether paid in cash, property, or services. Your employer will generally report your taxable compensation on Form W-2 and other information returns, such as Form 1099-R for certain retirement payments. Do not reduce the amount you report as taxable compensation on your return by withholdings for income taxes, Social Security taxes, union dues, or U.S. Savings Bond purchases. Your Form W-2 does not include in taxable pay your qualifying salary-reduction contributions to a retirement plan, although the amount may be shown on the form.

Attach Copy B of Form W-2 to your return; do not attach Forms 1099 unless there are withholdings.

Unemployment benefits are fully taxable. The benefits are reported to the IRS on Form 1099-G. You do not have to attach your copy of Form 1099-G to your return.

Income and expenses from self-employment are discussed in Chapter 40.

2.1 Salary and Wage Income

The key to reporting your pay is Form W-2, sent to you by your employer. It lists your taxable wages, which may include not only your regular pay, but also other taxable items, such as taxable fringe benefits. Table 2-1 explains how employee pay benefits and tax withholdings are reported on Form W-2.

Your employer reports your taxable pay under a simple rule. Unless the item is specifically exempt from tax, you are taxed on practically everything you receive for your work whether paid in cash, property, or services. Benefits that the law specifically excludes from tax are discussed in Chapter 3. The most common tax-free benefits are employer-paid premiums for health and accident plans, medical expense reimbursements, and group-term life insurance coverage up to $50,000.

Your employer will include in Box 1 of your Form W-2 the total wages, tips, and other compensation, before payroll deductions, that were paid to you during the year. Box 1 may include, in addition to regular wages and tips, the following types of taxable compensation:

• Bonuses (including signing bonuses)
• Taxable fringe benefits (Chapter 3)
• Per diem or mileage allowances exceeding the IRS rate (20.32–20.33)
• Expense allowances or business expense reimbursements under a non-accountable plan (20.34)
• Awards or prizes not exempt under 3.11
• Cost of group-term life insurance over $50,000 (3.4)
• Cost of accident and health insurance premiums paid by an S corporation for 2%-or-more shareholder-employees
• Deferred income that is currently taxable under a Section 409A nonqualified deferred compensation plan (2.7)

Compensation reported in Box 1 must be reported as wages on Line 7 of Form 1040 or 1040A, or Line 1 of Form 1040EZ. Other types of income must also be reported as wages on your return although they are not included in Box 1 of Form W-2, such as non-excludable dependent care (3.5) or adoption (3.6) benefits, tips not reported to your employer or allocated tips (26.8), disability pension shown on Form 1099-R if you are under your employer’s minimum retirement age, or excess salary deferrals to an employer retirement plan (7.16).

Withholdings for retirement plans. Amounts withheld from wages as your contribution to your pension or profit-sharing account are generally taxable as compensation unless they are tax-deferred elective deferrals under the limits allowed for Section 401(k) plans (7.16), simplified employee pension plans (8.16), SIMPLE IRAs (8.18), or tax-sheltered annuity plans (7.19). Elective deferrals are reported in Box 12 of Form W-2.

Wages withheld for compulsory forfeitable contributions to a nonqualified pension plan are not taxable if these conditions exist:

1. The contribution is forfeited if employment is terminated prior to death or retirement.
2. The plan does not provide for a refund of employee contributions and, in the administration of the plan, no refund will be made. Where only part of the contribution is subject to forfeiture, the amount of withheld contribution not subject to forfeiture is taxable income.

You should check with your employer to determine the status of your contributions.

Assigning your pay. You may not avoid tax on income you earned by assigning the right to payment to another person. For example, you must report earnings that you donate to charity, even if they are paid directly by your employer to a charity. If you claim itemized deductions, you may claim a contribution deduction for the donation; see Chapter 14. Assignments of income-generating intellectual property are held taxable to the assignee. However, if the assignor retained power or control of the property, the assignor could be held liable for the tax according to the 8th Circuit.

The IRS allowed an exception for doctors working in a clinic. The doctors were not taxed on fees for treating patients with limited income (teaching cases) where they were required to assign the fees to a foundation.

Gifts from employers. A payment may be called a gift but still be taxable income. Any payment made in recognition of past services or in anticipation of future services or benefits is taxable as wages even if the employer is not obligated to make the payment. However, there are exceptions for employee achievement awards (3.11).

To prove a gift is tax free, you must show that the employer acted with pure and unselfish motives of affection, admiration, or charity. This is difficult to do, given the employer-employee relationship. A gift of stock by majority stockholders to key employees has been held to be taxable.

Employee leave-sharing plan. Some companies allow employees to contribute their unused leave into a “leave fund” for use by other employees who have suffered medical emergencies or are disaster victims. If you use up your regular leave and benefit from additional leave that has been donated to the plan, you are taxed on the benefit; it is is reported as wages on your Form W-2 and subject to withholding taxes. If you are donating the leave, you are not taxed on the value.

“Golden parachute” payments. Golden parachute arrangements are agreements to pay key employees additional compensation upon a change in company control. If you receive such a payment, part of it may be deemed to be an “excess payment” under a complex formula in the law. You must pay a 20% penalty tax on the “excess” amount in addition to regular income tax on the total. The 20% penalty should be identified on Form W-2 with Code K in Box 12; see Table 2-1.

If the golden parachute payment is made to a non-employee, the company will report it in Box 7 (non-employee compensation) of Form 1099-MISC. If you are self-employed, report the total compensation on Schedule C (40.6) and compute self-employment tax on Schedule SE (45.3). Any “excess parachute payment” should be separately labeled in Box 13 of Form 1099-MISC. Multiply the Box 13 amount by 20% and report it as an “other tax” on Line 62 of Form 1040; label it “EPP.”

2.2 Constructive Receipt of Year-End Paychecks

As an employee, you use the cash-basis method of accounting. This means that you report all income items in the year they are actually received and deduct expenses in the year you pay them.

You are also subject to the “constructive receipt rule,” which requires you to report income not actually received but which has been credited to your account, subject to your control, or put aside for you. Thus, if you received a paycheck at the end of 2017, you must report the pay on your 2017 return, even though you do not cash or deposit it to your account until 2018. This is true even if you receive the check after banking hours on the last business day of the year and cannot cash or deposit it until the next year. The Tax Court has also ruled that receipt by an agent (e.g., an attorney) is constructive receipt by the principal.

If your employer does not have funds in the bank and asks you to hold the check before depositing it, you do not have taxable income until the check is cashed. If services rendered in 2017 are paid for by check dated for 2018, the pay is taxable for 2018.

The IRS has ruled that an employee who is not at home on December 31 to take delivery of a check sent by certified mail must still report the check in that year. However, where an employee was not at home to take certified mail delivery of a year-end check that she did not expect to receive until the next year, the Tax Court held that the funds were taxable when received in the following year.

2.3 Pay Received in Property Is Taxed

Your employer may pay you with property instead of cash. You report the fair market value of the property as wages.

If you receive your unrestricted company stock as payment for your services, you include the value of the stock as pay in the year you receive it. However, if the stock is nontransferable or subject to substantial risk of forfeiture, you do not have to include its value as pay until the restrictions no longer apply (2.18). You must report dividends on the restricted stock in the year you receive the income.

If you receive your employer’s note that has a fair market value, you are taxed on the value of the note less what it would cost you to discount it. If the note bears interest, report the full face value. But do not report income if the note has no fair market value. Report income on the note only when payments are made on it.

A debt canceled by an employer is taxable income.

Salespeople employed by a dealer have taxable income on receipt of “prize points” redeemable for merchandise from a distributor.

2.4 Commissions Taxable When Credited

Earned commissions are taxable in the year they are credited to your account and subject to your drawing, whether or not you actually draw them.

Do not report commissions that were earned in 2017 on your 2017 return if they cannot be computed or collected until a later year.

Advances against unearned commissions. Under standard insurance industry practice, an agent who sells a policy does not earn commissions until premiums are received by the insurance company. However, the company may issue a cash advance on the commissions before the premiums are received. Agents have claimed that they may defer reporting the income until the year the premiums are earned. The IRS, recognizing that in practice companies rarely demand repayment, requires that advances be included in income in the year received if the agent has full control over the advanced funds. A repayment of unearned commissions in a later year (2.8) is deductible on Schedule A, provided you itemize deductions for that year.

Salespeople have been taxed on commissions received on property bought for their personal use. In one case, an insurance agent was taxed on commissions paid to him on his purchase of an insurance policy. In another case, a real estate agent was taxed on commissions he received on his purchase of land. A salesman was also taxed for commissions waived on policies he sold to friends, relatives, and employees.

Kickback of commissions. An insurance agent’s kickback of his or her commission is taxable where agents may not under local law give rebates or kickbacks of premiums to their clients. The commissions are income and may not be offset with a business expense deduction; illegal kickbacks may not be deducted.

However, in one case, a federal appeals court allowed an insurance broker to avoid tax when he did not charge clients the basic first-year commission. The clients paid the broker the net premium (gross premium less the commission), which he remitted to the insurance company. The IRS and Tax Court held that the commissions were taxable despite the broker’s voluntary waiver of his right to them. He could not deduct them because his discount scheme violated state anti-rebate law (Oklahoma). On appeal, the broker won. The Tenth Circuit Court of Appeals held that since the broker never had any right to commissions under the terms of the contracts he structured with his clients, he was not taxed on the commissions. The court cautioned that if the broker had remitted the full premium (including commission) to the insurance company and then reimbursed the client after having received the commission from the company, the commission probably would have been taxable.

2.5 Unemployment Benefits

All unemployment benefits received in 2017 are taxable. You should receive Form 1099-G, showing the amount of the payments. Report the payments on Line 19 of Form 1040, Line 13 of Form 1040A, or Line 3 of Form 1040EZ.

Supplemental unemployment benefits paid from company-financed funds are taxable as wages and not reported as unemployment compensation. Such benefits are usually paid under guaranteed annual wage plans made between unions and employers.

Unemployment benefits from a private or union fund to which you voluntarily contribute dues are taxable as “other” income on Form 1040, but only to the extent the benefits exceed your contributions to the fund. Your contributions to the fund are not deductible.

Workers’ compensation payments (2.13) are not taxable.

Taxable unemployment benefits include federal trade readjustment allowances (1974 Trade Act), airline deregulation benefits (1978 Airline Deregulation Act), and disaster unemployment assistance (1974 Disaster Relief Act).

Repaid supplemental unemployment benefits. If you had to repay supplemental unemployment benefits to receive trade readjustment allowances (1974 Trade Act), taxable unemployment benefits are reduced by repayments made in the same year. If you repay the benefits in a later year, the benefits are taxed in the year of receipt and a deduction may be claimed in the later year. If the repayment is $3,000 or less, an “above-the-line” deduction is allowed; add it to your other adjustments to income on Line 36 of Form 1040; label it “sub-pay TRA.” If the repayment exceeds $3,000, you have the choice between the above-the-line deduction or a credit (2.8).

2.6 Strike Pay Benefits and Penalties

Strike and lockout benefits paid out of regular union dues are taxable as wages unless the payment qualifies as a gift, as discussed below. However, if you have made voluntary contributions to a strike fund, benefits you receive from the fund are tax free up to the amount of your contributions and are taxable to the extent they exceed your contributions.

Strike benefits as tax-free gifts. Here are factors indicating that benefits are gifts: Payments are based on individual need; they are paid to both union and non-union members; and no conditions are imposed on the strikers who receive benefits.

If you receive benefits under conditions by which you are to participate in the strike and the payments are tied to your scale of wages, the benefits are taxable.

Strike pay penalties. Pay penalties charged to striking teachers are not deductible. State law may prohibit public school teachers from striking and charge a penalty equal to one day’s pay for each day spent on strike. For example, when striking teachers returned to work after a one-week strike, a penalty of one week’s salary was deducted from their pay. Although they did not actually receive pay for the week they worked after the strike, they earned taxable wages. Furthermore, the penalty is not deductible. No deduction is allowed for a fine or penalty paid to a government for the violation of a law.

2.7 Nonqualified Deferred Compensation

The rules for determining whether tax may be deferred under a nonqualified deferred compensation plan are governed by Code Section 409A. Section 409A applies generally to amounts deferred after 2004. Amounts deferred before 2005 are “grandfathered,” and thus generally exempt, but they become subject to Section 409A (unless excluded under IRS rules) if the plan is materially modified after October 3, 2004.

Plans subject to and excluded from Section 409A. Unless an exception applies, Code Section 409A applies to all nonqualified deferred plans, including arrangements between an independent contractor and a service recipient, and a partner and partnership, under which the service provider has a legally binding right during a year to compensation that is not actually or constructively received, and which is payable in a later year. The law does not apply to qualified retirement plans (such as 401(k) plans), Section 403(b) tax-deferred annuities, SIMPLE accounts, simplified employee pensions, and Section 457 plans; these are excluded from the definition of “nonqualified deferred compensation plans.” Also excluded are welfare benefit plans such as vacation, sick leave, and disability programs.

The IRS has allowed exceptions for short-term deferrals, incentive stock options, employee stock purchase plan options, and certain stock appreciation rights, tax equalization payments, separation payments, reimbursement arrangements, and fringe benefits. For details, see the IRS final regulations (T.D. 9321, 2007-19 IRB 1123).

Section 409A requirements. Plans subject to Section 409A must meet detailed requirements pertaining to the timing of deferral elections and the availability of distributions. For example, a deferral election generally must be made prior to the beginning of the year during which the services will be provided, but special rules apply to short-term deferrals and deferrals with respect to forfeitable rights. Distributions before separation from service are generally allowed only if the participant is disabled or has an unforeseeable emergency, the distribution is used to satisfy a domestic relations order, the distribution is on a specific date or under a fixed schedule specified in the plan, or there has been a change in the ownership or effective control of the corporation or in the ownership of a substantial portion of the assets.

If the Section 409A requirements are not met at any time during a taxable year, all amounts deferred under the plan for all years are currently includible in a participant’s gross income to the extent that the amounts are not subject to a substantial risk of forfeiture and were not previously included in gross income.

Reporting of Section 409A plan deferrals and earnings on your tax return. Your employer may include 2017 plan deferrals in Box 12 of your Form W-2 using Code Y (reporting is optional). If deferrals are reported, Code Y should also be used to show earnings in 2017 on all deferrals, whether for 2017 or prior years. If any amounts are taxable because the Section 409A requirements have not been met, the taxable amount should be reported as taxable wages in Box 1 of Form W-2, and also shown in Box 12 using Code Z.

If you are not an employee, current year Section 409A deferrals of at least $600 and earnings on current and prior year deferrals may be reported in Box 15a of Form 1099-MISC. If any amounts are taxable because the Section 409A requirements have not been met, the taxable amount is reported in Box 15b and also included as non-employee compensation in Box 7 of Form 1099-MISC; this amount is generally subject to self-employment tax.

If there is a taxable amount, a penalty also must be paid equal to 20% of the includible compensation, plus interest at a rate that is 1% higher than the regular underpayment rate. The penalty and interest must be added to Line 62 on Form 1040, and identified as “NQDC”.

Financial health triggers and offshore rabbi trusts. Section 409A blocks the benefit of two funding arrangements that set aside assets to secure the payment of promised deferred compensation. If a nonqualified deferred compensation plan provides that assets will be restricted to payment of deferrals if the employer’s financial condition deteriorates, the setting aside of the assets will be considered a transfer of restricted property to the participants, taxable under the Section 83 rules (2.17). This is so even if the assets nominally remain available to satisfy the claims of the employer’s general creditors.

Also, a Section 83 transfer (2.17) is generally deemed to occur when assets to pay nonqualified deferred compensation are set aside in an offshore rabbi trust. Section 409A treats the funding of an offshore trust as a transfer of property to the participants, taxable under the Section 83 rules (2.17), unless substantially all of the services relating to the deferred compensation were performed in the foreign jurisdiction where the assets are held. A Section 83 transfer is deemed to occur whether or not the offshore assets are nominally available to satisfy the claims of the employer’s general creditors.

If deferrals are includible in a participant’s income because of the financial health trigger or offshore trust provisions, there is an additional 20% penalty plus interest at 1% more than the regular rate.

Rabbi trusts. If IRS tests are met, employer contributions to a domestic “rabbi trust” are not taxed until distributions from the trust are received or made available. The trust must be irrevocable and the trust assets must be subject to the claims of the employer’s creditors in the event of insolvency or bankruptcy. Employees and their beneficiaries must have no preferred claim on the trust assets.

Offshore rabbi trusts are subject to Section 409A, as discussed above.

2.8 Did You Return Wages Received in a Prior Year?

Did you return income in 2017 such as salary or commissions that you reported in a prior taxable year because it appeared you had an unrestricted right to them in the earlier year? If so, you may deduct the repayment as a miscellaneous itemized deduction. If the repayment of wages exceeds $3,000, the deduction is claimed on Line 28 of Schedule A and is not subject to the 2% of adjusted gross income (AGI) floor (19.1). However, if the repayment is $3,000 or less, the deduction must be claimed on Line 23 (“Other Expenses”) of Schedule A, where it is subject to the 2% floor.

Option of tax credit or deduction for repayments over $3,000. If your repayment of wages exceeded $3,000, you may either (1) claim the repayment as an “other” miscelleneous itemized deduction (Line 28 of Schedule A), or (2) you may claim a tax credit, based upon a recomputation of the prior year’s tax; see the Filing Instruction on this page.

Repayment of supplemental unemployment benefits. Where repayment is required to qualify for trade readjustment allowances, you may deduct the repayment from gross income. Claim the deduction as an “above-the-line” deduction on Line 36 of Form 1040, and to the left of the line write “sub-pay TRA.” The deduction is allowed even if you do not itemize. If repayment exceeds $3,000, you have the choice of a deduction or claiming a tax credit based on a recomputation of your tax for the year supplemental unemployment benefits were received, as explained in the Filing Instruction on this page.

Repayment of disallowed travel and entertainment expenses. If a “hedge” agreement between you and your company requires you to repay salary or travel and entertainment (“T & E”) expenses if they are disallowed to the company by the IRS, you may claim a deduction in the year of repayment. According to the IRS, you may not recalculate your tax for the prior year and claim a tax credit under the rules of Section 1341. However, an appeals court rejected the position taken by the IRS and allowed a tax recomputation under Section 1341 to an executive who returned part of a disallowed salary under the terms of a corporate by-law.

2.9 Waiver of Executor’s and Trustee’s Commissions

Commissions received by an executor for services performed are taxable as compensation. An executor may waive commissions without income or gift tax consequences by giving a principal legatee or devisee a formal waiver of the executor’s right to commissions within six months after the initial appointment or by not claiming commissions at the time of filing the usual accountings.

The waiver may not be recognized if the executor takes any action that is inconsistent with the waiver. An example of an inconsistent action would be the claiming of an executor’s fee as a deduction on an estate, inheritance, or income tax return.

A bequest received by an executor from an estate is tax free if it is not compensation for services.

2.10 Life Insurance Benefits

Company-financed insurance gives employees benefits at low or no tax cost.

Group life insurance. Group insurance plans may furnish not only life insurance protection but also accident and health benefits. Premium costs are low and tax deductible to the company while tax free to you unless you have nonforfeitable rights to permanent life insurance, or, in the case of group-term life insurance, your coverage exceeds $50,000 (3.4). Even where your coverage exceeds $50,000, the tax incurred on your employer’s premium payment is generally less than what you would have to pay privately for similar insurance.

It may be possible to avoid estate tax on the group policy proceeds if you assign all of your ownership rights in the policy, including the right to convert the policy, and if the beneficiary is other than your estate. Where the policy allows assignment of the conversion right, in addition to all other rights, and state law does not bar the assignment, you are considered to have made a complete assignment of the group insurance for estate tax purposes.

The IRS has ruled that where an employee assigns a group life policy and the value of the employee’s interest in the policy cannot be ascertained, there is no taxable gift. This is so where the employer could simply have stopped making payments. However, there is a gift by the employee to the assignee to the extent of premiums paid by the employer. The gift may be a present interest qualifying for the annual gift tax exclusion (39.2).

Split-dollar insurance. Where you want more insurance than is provided by a group plan, your company may be able to help you get additional protection through a split-dollar insurance plan. Under the basic split-dollar plan, your employer purchases permanent cash value life insurance on your life and pays all or part of the annual premium. At your death, your employer is entitled to part of the proceeds equal to the premiums he or she paid. You have the right to name a beneficiary to receive the remaining proceeds which, under most policies, are substantial compared with the employer’s share. Equity split-dollar arrangements allow employees to retain the right to the cash surrender value in excess of the premiums paid by the employer.

In final regulations applicable to split-dollar arrangements entered into or materially modified after September 17, 2003, the IRS has provided two sets of rules, depending on whether the employee or the employer owns the insurance policy (T.D. 9092, 2003-46 IRB 1055). If the employee is the owner, the employer’s premium payments will be treated as loans and the imputed interest will be taxed to the employee. If the employer owns the policy, the employee will be taxed on the value of the life insurance protection, the policy cash value that the employee has access to, and the value of any other economic benefits received from the policy.

In addition, the Section 409A rules for nonqualified deferred compensation plans (2.7) may also apply to certain types of split-dollar arrangements. Notice 2007-34 contains IRS guidance on applying the Section 409A rules and explaining the effect of modifications to a split-dollar arrangement.

2.11 Educational Benefits for Employees’ Children

Private foundations. The IRS has published guidelines for determining whether educational grants made by a private foundation established by an employer to children of employees constitute scholarships. An objective, nondiscriminatory program must be adopted. If the guidelines are satisfied, employees are not taxed on the benefits provided to their children. Advance approval of the grant program must be obtained from the IRS.

IRS guidelines require that:

• Grant recipients must be selected by a scholarship committee that is independent of the employer and the foundation. Former employees of the employer or the foundation are not considered independent.
• Eligibility for the grants may be restricted to children of employees who have been employed for a minimum of up to three years, but eligibility may not be related to the employee’s position, services, or duties.
• Once awarded, a grant may not be terminated if the parent leaves his job with the employer, regardless of the reason for the termination of employment. If a one-year grant is awarded or a multi-year grant is awarded subject to renewal, a child who reapplies for a later grant may not be considered ineligible because his parent no longer works for the employer.
• Grant decisions must be based solely upon objective standards unrelated to the employer’s business and the parent’s employment such as prior academic performance, aptitude tests, recommendations from instructors, financial needs, and conclusions drawn from personal interviews.
• Recipients must be free to use the grants for courses that are not of particular benefit to the employer or the foundation.
• The grant program must not be used by the foundation or employer to recruit employees or induce employees to continue employment.
• There must be no requirement or suggestion that the child or parent is expected to render future employment services.
• A percentage test generally must be met. The number of grants awarded in a given year to children of employees must not exceed (1) 25% of the number of employees’ children who were eligible, applied for the grants, and were considered by the selection committee in that year; or (2) 10% of the number of employees’ children who were eligible during that year, whether or not they applied. Renewals of grants are not considered in determining the number of grants awarded.

If all of the above tests other than the percentage test are met, the educational grant program can still qualify if the facts and circumstances indicate that the primary purpose of the program is to provide educational benefits rather than to compensate the employees.

Educational benefit trusts and other plans. A medical professional corporation set up an educational benefit plan to pay college costs for the children of “key” employees. Children enrolled in a degree program within two years of graduating from high school could participate in the plan. If an eligible employee quit for reasons other than death or permanent disability, his or her children could not longer receive benefits except for expenses actually incurred before termination. The company made annual contributions to a trust administered by a bank. According to the IRS, amounts contributed to the trust were a form of pay to qualified employees, because the contributions were made on the basis of the parents’ employment and earnings records, not on the children’s need, merit, or motivation. However, the employees could not be taxed when the funds were deposited because the children’s right to receive benefits was conditioned upon each employee’s future performance of services and was subject to a substantial risk of forfeiture. Tax is not incurred until a person has a vested right to receive benefits; here, vesting did not occur until a child became a degree candidate and incurred educational expenses while his or her parent was employed by the corporation. Once the child’s right to receive a distribution from the plan became vested, the parent of the child could be taxed on the amount of the distribution. The company could deduct the same amount.

The Tax Court and appeals court have upheld the IRS position in similar cases.

2.12 Sick Pay Is Taxable

Sick pay received from an employer is generally taxable as wages unless it qualifies as workers’ compensation (2.13). Payments received under accident or health plans are generally tax free (3.3), unless they constitute excess reimbursements (17.4). Payments from your employer’s plan for certain serious permanent injuries are tax free (3.3).

Disability pensions are discussed in 2.14.

Sick pay received from your employer is subject to income tax withholding as if it were wages. Sick pay from a third party such as an insurance company is not subject to withholdings unless you request it on Form W-4S.

2.13 Workers’ Compensation Is Tax Free

You do not pay tax on workers’ compensation payments for job-related injuries or illness. However, your employer might continue paying your regular salary but require you to turn over your workers’ compensation payments. Then you are taxed on the difference between what was paid to you and what you returned.

To qualify as tax-free workers’ compensation, the payments must be made under the authority of a law (or regulation having the force of a law) that provides compensation for on-the-job injury or illness. Payments made under a labor agreement do not qualify as tax-free workers’ compensation.

A retirement pension or annuity does not qualify for tax-free treatment if benefits are based on age, length of service, or prior plan contributions. Such benefits are taxable even if retirement was triggered by a work-related injury or sickness.

State law may impose a penalty for unreasonable delay in paying a worker’s compensation award. If the penalty is considered to have the remedial purpose of facilitating the injured employee’s return to work, the IRS may treat the penalty as part of the original tax-free compensation award.

Survivors of fallen state and federal public safety officers. Survivor benefits paid to families of police officers, firefighters, paramedics, and other public safety workers killed in the line of duty are excluded from gross income. The exclusion applies to (1) survivor benefits paid by the federal Bureau of Justice Assistance to families of fallen public safety officers, and (2) state-paid benefits to survivors of public safety officers who died as a result of injuries sustained in the line of duty, but the exclusion does not apply to state benefits that would have been paid even if the death had not been sustained in the line of duty.

Effect of workers’ compensation on Social Security. In figuring whether Social Security benefits are taxable (34.2), workers’ compensation that reduces Social Security or equivalent Railroad Retirement benefits is treated as a Social Security (or Railroad Retirement) benefit received during the year. Thus, the workers’ compensation may be indirectly subject to tax (34.2).

2.14 Disability Pay and Pensions

Disability pensions financed by your employer are taxable wages unless they are for severe permanent physical injuries that qualify for tax-free treatment (3.3), they are tax-free workers’ compensation (2.13), or they are tax-free government payments as discussed in this section.

Taxable disability pensions are reported as wages until you reach the minimum retirement age under the employer’s plan. After reaching minimum retirement age, payments are reported as a pension (7.24).

If you receive little or no Social Security and your other income is below a specified threshold, you may be eligible to claim a tax credit for disability payments received while you are under the age of 65 and permanently and totally disabled (34.7).

State short-term disability payments. Some states provide or require employers to provide short-term disability pay to workers who are temporarily unable to work due to a non-work related illness or injury, or pregnancy. For federal tax purposes, payments from such plans are taxable to the extent they were financed by your employer or are a substitute for unemployment benefits. For example, payments from the Rhode Island program are not taxable, and payments from California are not taxable unless they are a substitute for unemployment benefits. State disability payments from New York, New Jersey, and Hawaii are taxable to the extent of employer contributions.

Injury or sickness resulting from active military service. Disability pensions for personal injuries or sickness resulting from active service in the armed forces are taxable if you joined the service after September 24, 1975.

Military disability payments are tax free if before September 25, 1975, you were entitled to military disability benefits or if on that date you were a member of the armed forces (or reserve unit) of the U.S. or any other country or were under a binding written commitment to become a member. A similar tax-free rule applies to disability pensions from the following government agencies if you were entitled to the payments before September 25, 1975, or were a member of the service (or committed to joining) on that date: The Foreign Service, Public Health Service, or National Oceanic and Atmospheric Administration. The exclusion for pre–September 25, 1975, service applies to disability pensions based upon percentage of disability. However, if a disability pension was based upon years of service, you do not pay tax on the amount that would be received based upon percentage of disability.

VA pensions. Disability pensions from the Department of Veterans Affairs (VA) are tax free. If you retire from the military and are later given a retroactive award of VA disability benefits, the retirement pay received prior to the award (other than a lump-sum readjustment payment upon retirement) is retroactively made tax free to the extent of the VA disability determination. You may have more than the normal three-year period (47.2) to file a refund claim for any tax you paid on the amount that was retroactively determined to be a VA disability benefit. The refund deadline is extended for one year beginning on the date of the VA determination. However, a refund claim within the extended one-year period cannot be made for tax years that began more than five years before the date of the VA determination.

Social Security disability benefits. Disability benefits from the Social Security Administration (SSA) are treated as regular Social Security retirement benefits that may be taxable (34.2).

In one case, a veteran who received disability benefits from the SSA as well as a disability pension from the Department of Veterans Affairs (VA) for cancer caused by exposure to Agent Orange during the Vietnam War tried to exclude both benefits from income. The IRS did not dispute the exclusion for the VA payments, but it held that the SSA disability benefits were subject to tax as if they were Social Security retirement benefits. The Tax Court and the Second Circuit Court of Appeals rejected the taxpayer’s argument that his SSA disability benefits were excludable as amounts received for personal injuries/sickness resulting from active military service. The Second Circuit held that the military service exclusion is not applicable for SSA disability payments because they are a wage-replacement benefit based on the number of quarters of Social Security coverage, and are payable whether or not the disability arose from military service.

Disability pay of federal public safety officers. Disability benefits paid to federal public safety officers by the federal Bureau of Justice Assistance are tax free.

Pension based on combat-related injuries. Tax-free treatment applies to payments for combat-related injury or sickness that is incurred as a result of any one of the following activities: (1) as a direct result of armed conflict; (2) while engaged in extra-hazardous service, even if not directly engaged in combat; (3) under conditions simulating war, including maneuvers or training; or (4) that is caused by an instrumentality of war, such as weapons.

Terrorist attacks or United States military actions. Tax-free treatment applies to disability payments received by any individual for injuries incurred as the direct result of a terrorist attack against the United States or its allies. The exclusion also applies to disability income received as a direct result of a military action involving U.S. Armed Forces in response to aggression against the United States or its allies.

2.15 Stock Appreciation Rights (SARs)

Stock appreciation rights, or SARs, enable employees to receive the benefit of an increase in value of the employer’s stock between the date the SARs are granted and the date they are exercised. When the SARs are exercised, cash or stock may be delivered as payment for the post-grant appreciation. For example, when your employer’s stock is worth $30 a share, you get 100 SARs exercisable within five years. Two years later, when the stock price has increased to $50 a share, you exercise the SARs and receive $2,000 ($5,000 value at exercise minus $3,000 value at grant).

If IRS tests are satisfied, you are not taxed until you exercise the SARs and the post-grant appreciation is received. The situation has been complicated by the enactment of Code Section 409A (2.7), which restricts deferrals of income under nonqualified deferred compensation plans. However, the IRS has provided an exception to the Section 409A rules for SARs issued with an exercise price equal to the stock’s fair market value when the rights are granted.

2.16 Stock Options

Employees receiving statutory stock options do not incur regular income tax liability either at the time the option is granted or when the option is exercised. However, the option spread is generally subject to AMT (23.2). Statutory options include incentive stock options (ISOs) and options under an employee stock purchase plan (ESPP). Employees receiving nonstatutory (nonqualified) stock options generally must include the option spread in income for the year the option is exercised unless the stock does not become vested until a later year.

Incentive stock options (ISOs). A corporation may provide its employees with incentive stock options to acquire its stock (or the stock of its parent or subsidiaries). For regular income tax purposes, ISOs meeting tax law tests are not taxed when granted or exercised. Income or loss is not reported until you sell the stock acquired from exercising the ISO. However, for purposes of the alternative minimum tax (AMT), the excess of the fair market value of the stock at exercise over the option price is treated as an adjustment that may substantially increase AMT income. The AMT adjustment applies for the year of exercise or if later, the year in which your rights to the stock are transferrable or no longer subject to a substantial risk of forfeiture; see the Caution on this page.

To qualify as an ISO, the option must be exercisable within 10 years of the date it is granted and the option price must be at least equal to the fair market value of the stock when the option is granted. If the fair market value of stock for which ISOs may first be exercised in a particular year by an employee exceeds $100,000 (valued at date of grant), the excess is not considered a qualifying ISO. An ISO may be exercised by a former employee within three months of the termination of employment; if exercised after three months, income is realized under the rules for nonqualified options, discussed later in this section.

AMT consequences of exercising ISO. Although you do not realize taxable income for regular tax purposes when you exercise an ISO, you may incur a substantial liability for alternative minimum tax (AMT) (23.2). See the Caution on this page.

Form 3921 for ISO. You should receive Form 3921 (or equivalent statement) from the corporation for the year you exercise an ISO. Form 3921 shows the dates on which the ISO was granted and exercised, the exercise price per share, the fair market value per share on the exercise date, and the number of shares acquired when the option was exercised. Keep the Form 3921 in your records and use it to figure the gain or loss when you sell the shares; see “ Gain or loss on sale of ISO stock,” below. The Form 3921 entries can also be used to figure the AMT adjustment; see the Form 6251 instructions.

Gain or loss on sale of ISO stock. If the stock acquired by the exercise of the ISO is held for more than one year after acquisition and more than two years after the ISO was granted, you have long-term capital gain or loss (5.3) on the sale, equal to the difference between the selling price of the stock and the option price you paid when you exercised the ISO. If you sell to comply with conflict-of-interest requirements, the holding period rules are considered satisfied.

If you sell before meeting the one-year and two-year holding period tests, a gain on the sale is generally treated as ordinary wage income to the extent of the option spread (bargain element)—the excess of the value of the stock when you exercised the ISO over the option price. Any gain in excess of the spread is reported as capital gain. In figuring the capital gain, cost basis for the stock is increased by the amount treated as wages. If the fair market value of the stock declines between the date the option was exercised and the date the stock is sold, the amount that must be treated as wages is generally reduced. The ordinary income (wages) is limited to the actual gain on the stock sale where the gain is less than the option spread at exercise. However, the reduction to ordinary income does not apply on a sale of the stock to a related person or if replacement shares are purchased within the wash sale period (30.6) because the reduction applies only if a loss “would be” recognized if sustained (actual loss is not required for limitation to apply so long as a loss “would be” recognized).

If you have a loss on the sale of stock acquired by exercising an ISO, it is a capital loss and there is no ordinary wage income to report.

Employee stock purchase plans (ESPPs). These plans allow employees to buy their company’s stock, usually at a discount. A discount cannot exceed 15% (option price must be at least 85% of fair market value). The plan must be nondiscriminatory and meet tax law tests on option terms. Options granted under qualified plans are not taxed until you sell the shares acquired from exercising the option.

If you sell the stock more than one year after exercising the option and also more than two years after the option was granted, gain on the sale is capital gain unless the option was granted at a discount. If at the time the option was granted the fair market value of the stock exceeded the option price (which must be no less than 85% of fair market value), then when you sell the stock, gain is ordinary wage income to the extent of that discount. Any excess gain is long-term capital gain. A loss on the sale is long-term capital loss.

If you sell the acquired stock before meeting the one-year and two-year holding period tests, you must report as ordinary wage income the option spread—the excess of the value of the stock when you exercised the option over the option price. This amount must be reported as ordinary income even if it exceeds the gain on the sale (which would occur if the sale price were lower than the exercise price). Add the ordinary income amount to your cost basis for the stock. If the increased basis is less than the selling price, the difference is capital gain. You have a capital loss if the increased basis exceeds the selling price.

For the year that you sell stock acquired at a discount under an ESPP, you should receive Form 3922 (or equivalent statement from the corporation). Form 3922 shows the dates the option was granted and exercised, the fair market value per share on the grant date and also the exercise date, the exercise price per share, and the number of shares sold.

Nonstatutory (nonqualified) stock options. A nonstatutory stock option (also called a nonqualified option) can in some cases be considered nonqualified deferred compensation subject to the requirements of Code Section 409A (2.7). Under IRS regulations, the Section 409A rules apply if the exercise price can be less than the value of the underlying stock when the option is granted or the option permits any other deferral feature.

If the Section 409A rules do not apply, the amount of income to include and the time to include it depends on whether the option has a readily ascertainable fair market value when the option is granted. It is very rare for a nonstatutory option to be actively traded on an established securities market or to meet the other tests in IRS regulations for having a readily ascertainable fair market value.

In the usual case where there is no readily ascertainable fair market value for the option at the time it is granted, no income is realized on the receipt of the option. Income will not be realized until the year the option is exercised, or if later, the year your rights to the stock become vested. If the stock is not vested when you exercise the option, income is deferred until the vesting year under the restricted property rules (2.17). In the year that you become vested in the stock, you must report as ordinary wage income the value of the stock (as of the vesting date), minus the amount you paid.

If you receive vested stock when the option is exercised, you are taxed on the difference between the fair market value of the stock when you exercise the option and the option price. For example, in 2017, you exercise a nonstatutory stock option to buy 1,000 shares of your employer’s stock at $10 a share when the stock has a value of $30 a share. Your rights to the stock are vested when you buy it. When you exercise the option you are treated as receiving wages of $20,000, equal to the option spread ($30,000 value – $10,000 cost). This income is subject to withholding taxes that you will have to pay out-of-pocket at the time of exercise unless the withholding can be taken from regular cash wages. The taxable spread will be reported as wages on Form W-2 and will be separately identified in Box 12, using Code V. Your cost basis for the shares is increased by the ordinary income reported for exercising the option. If you hold the shares for more than one year after exercising the option and then sell them for $35,000 ($35 a share × 1,000 shares), you will have a $5,000 long-term capital gain ($35,000 – $30,000 basis ($10,000 cost plus $20,000 taxed as wages at exercise)).

If in a rare case a nonstatutory stock option has an ascertainable fair market value, the value of the option less any amount you paid is taxable under the restricted property rules (2.17) as ordinary wage income in the first year that your right to the option is freely transferable or not subject to a substantial risk of forfeiture. However, a Section 83(b) election (2.17) may not be made for the nonstatutory option. For other details and requirements, see IRS Regulation Section 1.83-7.

Nonstatutory stock options may be granted in addition to or in place of incentive stock options. There are no restrictions on the amount of nonstatutory stock options that may be granted.

2.17 Restricted Stock

If in return for performing services you buy or receive company stock (or other property) subject to restrictions, special tax rules apply. Unless you make the Section 83(b) election discussed below, you do not have to pay tax on the stock until the first year in which it is substantially vested, which is the year that the stock either becomes transferable or is not subject to a substantial risk of forfeiture. A risk of forfeiture exists where your rights are conditioned upon the future performance of substantial services. In the year the property becomes substantially vested, you must report as compensation (wages) the difference between the amount, if any, that you paid for the stock and its value at the time the risk of forfeiture is removed. The valuation at the time the forfeiture restrictions lapse is not reduced because of restrictions imposed on the right to sell the property. However, restrictions that will never lapse do affect valuation.

SEC restrictions on insider trading are considered a substantial risk of forfeiture, so that there is no tax on the receipt of stock subject to such restrictions. However, the SEC permits insiders to immediately resell stock acquired through exercise of an option granted at least six months earlier. As the stock acquired through such options is not subject to SEC restrictions, the executive is subject to immediate tax upon exercise of an option held for at least six months.

If the stock is subject to a restriction on transfer to comply with SEC pooling-of-interests accounting rules, the stock is considered to be subject to a substantial restriction.

Non-employees. The tax rules for restricted property are not limited to employees. They also apply to independent contractors who are compensated for services with restricted stock or other property.

Sale of property that is not substantially vested. If you sell restricted property in an arm’s-length transaction before it has become substantially vested and you did not make the Section 83(b) election discussed below, gain on the sale (amount realized minus what you paid) must be reported as compensation income for the year of the sale. If the sale is to a related person or is otherwise not at arm’s length, compensation must be reported not only for the year of sale but also for the year the original property becomes substantially vested, as if you still held it. In the later year, the compensation income equals the fair market value of the stock minus the total of the amount you paid for it and the compensation reported on the earlier sale.

Election to include value of restricted stock in taxable pay when stock is received (Section 83(b) election). Although restricted stock is generally not taxable until the year in which it is substantially vested, you may elect to be taxed in the year you receive it on the unrestricted value (as of the date the stock is received), less any payment you made. This election, called a Section 83(b) election, must be made by filing a signed statement with the IRS (at the Service Center where you file your return) no later than 30 days after the date the stock is transferred to you. Also give a copy of the statement to the employer or other party for whom you provided the services. The IRS no longer requires (as it did for pre-2015 transfers) that a copy of the statement be attached to your return for the year in which the stock was transferred to you (this requirement was deleted because its prevented the return from being e-filed).

The statement must specify that you are making the election under Section 83(b) and include the following: your name, address, Social Security number, the year for which you are making the election, a description of the stock and the restrictions on the stock, the date you received the stock, the fair market value of the stock at receipt (ignoring restrictions unless they never lapse), your cost, if any, for the stock, and a statement that you have provided a copy of the statement to your employer or other party for whom the services were provided. The IRS has provided a sample election statement in Revenue Procedure 2012-29 that you can use to make the election.

If you make the election, you recognize ordinary income (wages) based on the value of the stock when it is received, but thereafter you are treated as an investor and later appreciation in value is not taxed as pay when your rights to the stock become vested. When you sell the stock, your basis for figuring capital gain or loss is your cost basis increased by the amount of income you reported as pay under the Section 83 (b) election. If you forfeit the stock after the election is made, a capital loss (5.4) is allowed for your cost minus any amount realized on the forfeiture. The election may not be revoked without the consent of the IRS.